Monday, March 10, 2014

Housing, Interest Rates, Rents, and Inflation

I have floated the idea that housing prices during the housing boom could be explained largely by low real long-term interest rates.  Home ownership can be described as pre-paid rent - a long position in a very long-duration, inflation-protected bond.

This graph basically tells that story:

In this graph, I compare bonds, stocks, and houses all based on the same mental framework - the price of each type of asset at any point in time, expressed in proportion to a stable measure of returns.  Bonds in the secondary market are valued this way, but bonds are usually reported in terms of yield.  Homes are basically valued this way, since implied rent is a fairly stable measure of cash flow.  Stocks are basically valued this way, except that instead of a stable coupon rate, stocks represent a volatile earnings stream.

Here, I have attempted to present all of these assets in a way that can be comparable.  And, the point I have been making in my housing posts is that, when we use a standardized mental framing, we see that home prices were never out of line compared to the other asset classes.  They remained very low in the 1990's, and at the top of the housing boom, the relative value of homes in 2005 compared to the 1980's was similar to a 30 year bond.  A home is essentially a perpetuity of rent payments on real property, so price behavior similar to a 30 year + bond is hardly uncalled for.  (The equivalent rent component that I use to construct the Price-to-Rent price index only goes to 1987, but, as you can see in the graph below, PtR was high in 1978-1979, and bottomed out in 1983, along with the other asset prices shown here.)

Also, I will note here that it would be incoherent to claim that high long-duration bond prices are sign of loose money and a signal for the Fed to tighten.  Yet, this is basically how Fed watchers, and the Fed itself, have been interpreting the 2000's.  Both long term bonds and homes were "expensive", yet everyone "knows" that the Fed was too loose in the 2000's.

So, I say, home prices weren't too high in the 2000's.  Instead, a lack of access to the home market, created by the peculiar way we finance real estate investments, has frequently led to markets where home prices were not bid high enough.  The frictions dampening home demand were increasing the implied yield on home ownership, which means that these frictions have frequently kept home prices too low, making homes a very good investment for those who could qualify for the financing.  This is why conventional wisdom about buying a home usually worked.  It didn't work in the 2000's because the behavior of home prices in the 2000's was much more bond-like, did not reflect a liquidity premium, and therefore homes were not necessarily appropriate investment vehicles for many households that could qualify for them.

Price/Dividend and Price/Rent Ratios
Prices are relatively low again, because the mortgage credit market has flatlined.  Price-to-rent was surprisingly high in the late 1970's, even in the face of double-digit nominal rates, because real long term rates were very low at the time - most of the high rates were a product of a high inflation premium.  Here is a graph from this paper, which shows price-to-rent multiples farther back in time than the data I show above.  As this graph shows, home prices, relative to rent, were rising into the late 1970's until the monetary shock of the early 1980's led to a long period of high real long term rates, and declining home prices, relative to rents.

Moving into Equilibrium

If this effect is somewhat dominant, we would expect rising prices to drive up land prices, then new home supply would dampen home prices.  This would pull future house supply back in time, increasing current supply and pulling down rents.  These competing forces push in opposite directions.  This should lead to an association of low real rates with both high home prices and deflationary pressures in the equivalent rent component of the CPI.  This is why I think the complaint that the housing component of the CPI understated inflation in the 2000's is misguidedHigh home prices that are a product of low real interest rates would be associated with consumption disinflation.
P/R (red, right scale), Rent (blue, left scale)

Interest Rate series are on the right scale, which is inverted
I'm using Case-Shiller data with rent data that only goes back to 1987.  Until the late 1990's, relative implied rent inflation and the house price-to-rent ratio tended to move together, probably reflecting business cycle and demographic factors that were driving the price of homes.  Note that, while real and nominal interest rates had declined from their peaks in the early 1980's, they generally plateaued in the 1990's at levels that weren't especially low.

But, starting in 1998, home prices began to rise.  At this point, the relationship between prices and rents inverts, so that from 1998 to 2007, rising prices are associated with less inflationary rents.  Rates fell into the 2001 recession, but coming out of that recession, long term rates remained low, so that real long term rates stepped down permanently after 2000.  (Keep in mind that interest rates and prices are inversely proportional, which means that prices rise more quickly with each fall in rates.)  This period where real and nominal rates were significantly lower than any recent experience is when house prices accelerated and house prices moved in the opposite direction from rents.  This is what we would expect in an environment where low real rates were the dominant factor.

Note that from 2005 to 2007, real rates rebounded slightly, and at the same time Price-to-Rent retrenched slightly and rent inflation increased.  But, when the Fed began sucking liquidity out of the economy in 2007, both home prices and rents collapsed.


Since 2007-2010, home prices have rebounded somewhat because of the continued low real rate environment, in spite of a hobbled banking system.  Rents have rebounded somewhat because of the lack of homebuilding since the crisis.

Real long term rates are still at least 1% below the low levels we saw in 2002-2004.  If I am on the right track here, that means that even in a rate environment with some more long term rate increases, as banks recover, we should be prepared to see home prices increase by another 40%, in real terms.  We should also expect to see home building doubling from its current levels.  And, we should expect this to be a disinflationary phenomenon.

For a start, it's probably worth taking a look at a long position on homebuilders with financial and operating leverage or other firms that are leveraged for higher homebuilding quantities and prices.

Secondarily, as I have expressed before, I am afraid that in this scenario, there will be a groundswell of public calls for the Fed to pop the housing "bubble", and we will be thrown unnecessarily into another recession, where the Fed will be tightening the money supply in an environment of low real rates and low inflation.


  1. I read several of your posts and they are all very good. And the Fed will tighten--any hint of inflation or "bubbles" and it will do what it compulsively wants to do, and that is is liking asking an alcoholic, "Should we have a drink now?"

    1. Thanks, Benjamin. I'm afraid you're right.